Financial Development and Financial Development and Economic - - PDF document

Financial Development and Financial Development and Economic Growth: What we know Economic Growth: What we know and What we can do about it? and What we can do about it?

Professor Kabir Hassan University of New Orleans, USA Email: KabirHassan63@gmail.com Cell Number: 610-529-1247

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Outline Outline

1.

Financial Development: Basic Concepts and Measures

2.

Financial Development and Economic Growth and Welfare: What we know?

3.

Financial Development: What we know about its Process?

4.

Financial Instability and Financial Development

5.

Financial Inclusion Versus Financial Development

6.

Financial Crisis and Islamic Finance

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• 1. Financial Development: Basic Concepts and Measure
• 1. Financial Development: Basic Concepts and Measures

s

1.1 Why do financial markets and 1.1 Why do financial markets and intermediaries exist? intermediaries exist?

Frictionless Arrow-Debreu world of complete Market:

Risk- fully and efficiently internalized in the price system Suppliers of fund would deal directly in the market with the users of funds Neither of them need to use financial service providers.

But in reality, Arrow-Debreu world does not exist.

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There exist two types of market frictions: First: Agency frictions: Asymmetric informational frictions - lead to the commonly known market failures of adverse selection, moral hazard and shirking, and false reporting. Enforcement frictions- limit the scope for contracting because they limit pledgeability. As one party has difficulties in credibly committing to repay, financial contracts are effectively limited to those that can be effectively collateralized

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• 1. Financial Development: Basic Concepts and Measure
• 1. Financial Development: Basic Concepts and Measures

s

1.1 Why do financial markets and 1.1 Why do financial markets and intermediaries exist? intermediaries exist?

There exist two types of market frictions: Second: Collective Frictions: Collective frictions constrain participation. High transaction costs and the increase in liquidity risk and no diversification

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• 1. Financial Development: Basic Concepts and Measure
• 1. Financial Development: Basic Concepts and Measures

s

1.1 Why do financial markets and 1.1 Why do financial markets and intermediaries exist? intermediaries exist?

The results:

Individuals involved in financial contracting search for ways to cope with—and limit the costs and risks deriving from—these frictions and failures. Financial intermediaries and financial markets emerge

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• 1. Financial Development: Basic Concepts and Measure
• 1. Financial Development: Basic Concepts and Measures

s

1.1 Why do financial markets and 1.1 Why do financial markets and intermediaries exist? intermediaries exist?

The results:

Financial intermediaries and financial markets emerge and usually perform multiple functions such as:

• 1. facilitating the trading, hedging, diversification, and

pooling of risk;

• 2. providing insurance services;
• 3. allocating savings and resources to the appropriate

investment projects;

• 4. monitoring managers and promoting corporate control

and governance;

• 5. mobilizing savings efficiently; and
• 6. facilitating the exchange of goods and services.

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• 1. Financial Development: Basic Concepts and Measure
• 1. Financial Development: Basic Concepts and Measures

s

1.1 Why do financial markets and 1.1 Why do financial markets and intermediaries exist? intermediaries exist?

1. 1. Financial Development: Basic Concepts and Measures Financial Development: Basic Concepts and Measures

1.2 1.2 How to measure Financial How to measure Financial Development? Development?

Instrumental approach: the types of financial

instruments and how they have risen.

Structural approach: the form and organization of

financial intermediaries and markets

Operational Approach: how institutions actually

• perate, kinds of credit granted, and the types of

resources granted.

Process Approach (a composite Approach): the

interplay of forces shaping financial system

Inclusion Approach: Access, quality, usage and

impact

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2. 2. Financial Development and Economic Growth Financial Development and Economic Growth and Welfare: What we and Welfare: What we know? know?

2.1 2.1 Five Views: Five Views:

Finance and growth expand simultaneously

• Luintel and Khan (1999)

Abu-Bader and Abu-Qarn (2008) Finance promotes Growth - Schumpeter (1911), King and Levine (1993), Beck et al. (2000) and Haiss and Fink (2006) Finance doesn’t matter in growth- Lucas (1988) Finance follows growth- Robinson (1952), Gupta (1984), Demetriades and Hussein (1996) Finance matters because financial crises hurt growth

• IMF/World Bank

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Part B. Financial Development and Economic Growth and Welfare Part B. Financial Development and Economic Growth and Welfare

B.2 B.2 What the Theory Says? What the Theory Says?

Impact of Financial Development

improves the efficiency with which those savings are used and

increasing the amount of capital and productivity.

Better screening and monitoring of borrowers can lead to more

efficient resource allocation.

Share risk associated with high-quality investment. Improvement

• n risk-sharing can enhance savings rates and promote

innovation, which will ultimately promote economic growth.

Help to accommodate macroeconomic shocks Help to reduce poverty and undernourishment Better health, education and Gender Equality Help to mitigate a variety of risks

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Part B. Financial Development and Economic Growth and Welfare Part B. Financial Development and Economic Growth and Welfare

B.2 B.2 What the Theory Says? What the Theory Says?

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2. 2. Financial Development and Economic Growth Financial Development and Economic Growth and Welfare: What we and Welfare: What we know? know?

2.2 2.2 What the Empirics Say? What the Empirics Say?

First empirical study: Goldsmith (1969) – Found relationship

but remained uncertain of the direction of causality.

Pure cross country Studies: King and Levine(1993a,b,c),

Dregorio and Guidotti (1995) Deidda and Fattouh (2002), McCaig and Stengos (2005) and - FD exerts a positive impact

• n growth and welfare.

Criticism of cross-country analysis: neglects some of the more country specific effects. Panel /Time Series: Levine et al. (2000), Calderon and Liu

(2003), Xu (2000), Christopoulos and Tsionas (2004) and Apergis et al (2007)-Less Clear evidence than cross-section

• analysis. But still supports a positive role of financial

development.

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2. 2. Financial Development and Economic Growth Financial Development and Economic Growth and Welfare: What we and Welfare: What we know? know?

2.2 2.2 What the Empirics Say? What the Empirics Say?

Arestis, Demetriades, and Luintel (2001): focus on link between

real growth and stock market development, long-run relationships causality may change, the relationship show substantial variation

Fink, Haiss and Hristoforova (2006): focus on bond market and

economic growth. Interdependence between bond market capitalization and real output growth.

Rajan and Zingales (2003): the process is diverse and complex.

Debatable empirical results, but strong consensus for positive role of FD on growth and welfare

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3. 3. Financial Development: What we know about Financial Development: What we know about its its Process? Process?

Finance pierces through the path of least resistance, which depends

• n the state of development, interest groups, the effectiveness of

public policy, and the forces of competition, innovation and regulatory arbitrage. Process of Financial Development: Demand Side

Needs Frictions Public Response Private Response Structure Failures

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3. 3. Financial Development: What we know about Financial Development: What we know about its its Process? Process?

Process of Financial Development: the supply side

Needs Frictions Public Response Private Response Structure Failures Participants Innovation Technological Innovation Competition Regulatory Arbitrage Enabling Environment

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3. 3. Financial Development: What we know about its Process? Financial Development: What we know about its Process?

3.1 3.1

Financial Activities and Financial Financial Activities and Financial Development Development

Early Finance Intermediate Finance Mature Finance

Information and Lending Personal Lending Basic Accounting Relationship Lending Advanced Accounting Credit Registries Basic Governance Arms-length Lending Fair Value Accounting Scoring and Rating Advanced Governance Collateral Personal Collateral Non-tradable Collateral Tradable Collateral Assets Backed Securities Multilateral Clearing Diversificatio n and Pooling Bank Deposits Money Market Funds Early Portfolio Management Mature Portfolio Management Insurance Non-life Insurance Basic Insurance Bank Deposits Early Derivatives Annuities Repo Transactions Mature Derivatives Liquidity Bank Assets Liquidity Bank Liability Liquidity Funding Liquidity Market Liquidity Delegation Basic Banking Basic Insurance Intermediate Banking Intermediate Insurance Money Market Funds Personal Funds Mature Banking Mature Insurance Mutual Funds Hedge Funds Venture Capital Private Equity and Market Makers 16

3. 3. Financial Development: What we know about its Process? Financial Development: What we know about its Process?

3.1 3.1

A Regulatory Framework for A Regulatory Framework for Financial Financial Development Development

• 1. Limit the collective failures associated with risk aversion by

absorbing and spreading out risk more evenly across individuals and over time through issuing guarantees, purchasing assets, or providing loans; and

• 2. Lessen agency or collective failures by directly providing

financial services (thereby assuming a public agency role) through the use of general public infrastructure or the creation of specialized public financial institutions.

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3. 3. Financial Development: What we know about its Process? Financial Development: What we know about its Process?

3.1 3.1

A Regulatory Framework for A Regulatory Framework for Financial Financial Development Development

1.

Lessen agency or collective frictions by improving the enabling environment (normalizing contract rights and rules, providing information, enhancing transparency requirements, standardizing instruments and activities, boosting the judiciary, etc.);

2.

Limit agency or collective failures (or lessen their impact) by protecting the uninformed, helping internalize externalities, and limiting free riding through regulation or taxes and subsidies;

3.

Limit pure coordination failures (i.e., failures to engage in socially desirable activities or to pull out from ongoing activities in ways that are socially harmful) by engaging in catalytic support, providing lending of last resort, insuring deposits, facilitating resolution arrangements, mandating participation (e.g., in automobile insurance or pension funds), etc.;

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4. 4. Financial Stability and Financial Financial Stability and Financial Development Development

A financial system that is very heavily supervised and

regulated may be very stable, but such a control system would hamper financial development and innovation and risk taking, and thus many reduce the opportunities for long-run growth.

Lack of stability that tigers financial crises is also costly and

• inefficient. It leads to severe economic downturns and the

large economic and fiscal costs of cleaning up a financial system in distress and crisis.

Trade-off between the stability of financial system and degree

• f innovation and sophistication.

Financial stability is an important component of financial

development

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4. 4. Financial Stability and Financial Development Financial Stability and Financial Development

4.1 4.1 Consequences of Financial Consequences of Financial Instability Instability

Developed financial system seems always

prone to financial crisis.

Financial instability and the failure of the

proper working of the financial system are associated with different kinds of cost:

• Slower economic growth and negative

effects on long-term welfare.

• Social deadweight loss due to increase in

debt restructurings and increase in bankruptcies among households, corporate firms and financial institutions.

• Fiscal costs due to government

intervention

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4. 4. Financial Instability and Financial Development Financial Instability and Financial Development

4.1 4.1 Consequences of Financial Instability Consequences of Financial Instability

Total Government cost of fiscal Bailout Country Period Total Costs of fiscal bailout as % of GDP China 1990s 47 Korea Late 1990s 28 Malaysia Late 199s 16 Thailand Late 1990s 35 Bulgaria 1995-97 13 Czech Republic 1991-1994 12 Hungary 1991-95 10 Russia 1998-99 5-7 Turkey 2000-03 30 Finland 1991-94 11 Japan 1990s 24 Spain 1990s 175 Argentina 1980-82 55 Chile 1982-86 55 Ecuador Late 1990s 20 Jamaica 1995-20000 44 United States 1984-91 18 Venezuela 1994-95 3 Source: The financial Development Report 2008

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4. 4. Financial Instability and Financial Development Financial Instability and Financial Development

4.2 4.2 Issues of Financial Crises Issues of Financial Crises

Financial Crises: when a significant number of financial institutions become financially distressed and need to be closed down, merged, or restructured. Financial crises often preceded by Asset bubble

and the Credit bubbles.

Asset bubble, which go as far back as the Dutch tulip-mania of the 17th century, occur when an asset prices rises above its underlying fundamental value. Asset bubbles can occur for any financial or real assets, but the recent experience shows that they are prevalent in equity markets and in housing and real estate markets. Many assets bubbles have been associated with episodes of easy monetary policy and excessive credit growth.

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4. 4. Financial Instability and Financial Development Financial Instability and Financial Development

4.2 4.2 Issues of Financial Crises Issues of Financial Crises

• The perverse interaction between easy money, assets bubbles, credit

growth, and leveraging that feeds assets bubbles has been observed in many episodes.

• The 2007-09 crisis in the United States was preceded by easy money and

easy credit that triggered the process of asset bubbles and excessive leverage of financial system.

• Should Monetary Policy respond to restrict Asset bubbles and Credit

Bubbles?

• 1. A wide range of analytical models suggests that optimal

monetary policy should react to assets prices and assets bubbles above and beyond its reaction to the deviation of growth and inflation from their target.

• 2. Recent experience of the UK, Australia, and New Zealand

shows that monetary authorities can successfully control bubbles with monetary tightening without causing severe recession.

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4. 4. Financial Instability and Financial Development Financial Instability and Financial Development

4.2 4.2 Issues of Financial Crises Issues of Financial Crises

The Use of Credit policy instruments to limit assets bubbles

and Credit Bubbles

In considering an appropriate policy response to asset

bubbles and credit bubbles, one should not be limited to traditional monetary policy alone.

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25 Chart 1: Causes and consequences of financial crisis Causes of financial crisis Description Risk/Consequence Leverage Borrowing to finance investment Bubble that leads to bankruptcy Asset-liability mismatch The disparity between a bank’s deposits and its long term assets leads to the inability of banks to renew short term debt they used to finance long term investments in mortgage securities Bank runs Regulatory failure Improper (insufficient/excessive) regulatory control:

• Insufficient regulation:

1) Results in failure of making institutions’ financial situation publicly known (lack of transparency) 2) Makes it possible for financial institutions to operate without having sufficient assets to meet their contractual obligations.

• Excessive regulations that require banks to increase their capital when

risks rise leading to substantial decrease in lending when capital is in short supply.

• Excessive risk-taking
• Financial crisis (of 2008)

Potential deterioration of financial crisis Fraud, corruption and greed

• Enticing depositors through misleading claims about their investment

strategies and manipulating information.

• Creating financial assets without any real economic activity
• Extreme economic greed overrides basic ethical consideration in

investments Subprime mortgage crisis Contagion Where the failure of one particular financial institution to meet its financial

• bligations (due to lack of liquidity, bad loans or a sudden withdrawal of

savings) causes other financial institutions to be unable to meet their financial obligations when due. Such a failure may cause damage to many

• ther institutions and threatens the stability of financial markets

Systemic risk Money supply Uncontrolled printing of paper money that is not backed by real assest/commodity (gold) Higher inflation

Source: Derived from wikipedia, the free encyclopedia. www.en.wikipedia.org/wiki/Financial

Figure 1: Causes of the US Figure 1: Causes of the US Subprime Subprime Mortgage Crisis Mortgage Crisis

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SYSTEMIC RISK SYSTEMIC RISK

Systemic risk episodes are quite

common.

Such episodes have always existed -

even before derivatives and hedge funds.

Of the 180 IMF member countries

more than 130 had experienced a banking crisis, a currency crisis or both (“Twin Crises”).

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BANKING & SYSTEMIC RISK BANKING & SYSTEMIC RISK

Bankruptcy, in sectors other than

banking, dos not lead to fears of contagion and meltdown.

Bankruptcy of financial institutions, on

the other hand, is uniquely threatening since the banking sector is in many ways unique. Two main reasons for this:

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SYSTEMIC RISK & CONTAGION SYSTEMIC RISK & CONTAGION

1.) Credit is the lifeblood of the economic

• system. The banking system provides the

plumbing that allows credit to flow smoothly from one sector to another. A problem in this sector immediately affects every other component of the economy. 2.) The money multiplier effect means that even a small decrease in credit has an

• utsized impact on consumption and GDP.

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SUMMARY STATISTICS SUMMARY STATISTICS

CURRENCY CRISES BANKING CRISES

1970’s: 26 Currency Crises 1980-95: 50 Currency Crises 1980-97: 158 Currency Crises

• Av. Output Loss: 7.1%
• Av. Recovery Time: 1.6 years

1970’s: 3 Banking Crises 1980-95: 23 Banking Crises 1980-97: 54 Banking Crises

• Av. Output Loss: 14.2%
• Av. Recovery Time: 3.1 years

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THE EMPIRICS OF CURRENCY & THE EMPIRICS OF CURRENCY & BANKING CRISES BANKING CRISES

Currency crises are roughly 3 times

more frequent than banking crises.

Banking crises are more virulent than

currency crises in terms of economic loss.

Banking crises cost twice as much

and last twice as long as currency crises.

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THE COST OF A FINANCIAL CRISIS THE COST OF A FINANCIAL CRISIS

Countries Cost of Crisis (GDP Loss) Argentina (1980-82) 55% Japan (1990’s) 20% Korea (1997) 60% Indonesia (1997) 80% U.S. TARP Program (2008) $750 billion How expensive is the TARP program in relation to country GDP?

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SYSTEMIC RISK SYSTEMIC RISK

The underlying reason for the periodic

recurrence of financial crises has to do with the natural operation of a capitalist system.

Financial crises are driven by a self

perpetuating, inexorable cycle of economic links.

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Credit Expansion Fuels Further Increases in Asset Values Bubble Develops Further Increase in Credit, so on .... Asset Values Rise Credit Expands

THE SELF PERPETUATING CYCLE OF ASSET THE SELF PERPETUATING CYCLE OF ASSET PRICE BOOMS PRICE BOOMS

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BANK CRISIS & CURRENCY CRISIS (“TWIN CRISES”) Irrational Exuberance or Loose Monetary Policy Asset Bubble Develops Bubble Bursts Loan Defaults, Bank Insolvency, Capital Flows Out Currency Depreciation Import Costs go up, Inflation, Central Bank loses Reserves to Defend a Fixed Exchange Rate Credit Contraction, Growth Slowdown, Currency Crisis feeds Bank Crisis Austerity Programs, Structural Reforms, IMF Loans, etc.

ASSET PRICE BOOMS AND BUSTS ASSET PRICE BOOMS AND BUSTS

The Boom-Bust cycle is usually broken

when the government steps in. Standard policy measures include:

Using fiscal policy to stimulate aggregate

demand by increasing government spending.

Using monetary policy to increase credit.

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THE GREAT DEPRESSION (1929 THE GREAT DEPRESSION (1929-

• 39)

39)

The Great Depression was so called

because it was the longest, widest and deepest economic devastation the world had known.

The threat of another Great

Depression, and the incorrect policy choices that caused it, informed almost every major policy decision during the current crisis.

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THE GREAT DEPRESSION (1929 THE GREAT DEPRESSION (1929-

• 39)

39)

The most obvious effect of the Great

Depression was on long term stock market values.

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39

• 90%

THE GREAT DEPRESSION THE GREAT DEPRESSION

At the depth of the Depression, the

stock market dropped by 90%.

The stock market took 25 years (an

entire generation!) to regain the values that were eroded at the start of the depression.

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THE GREAT DEPRESSION THE GREAT DEPRESSION

For an equity driven society like the

modern day United States such a debacle would have catastrophic economic consequences for tax revenues, state funds, pension funds and individual retirement values.

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THE CRASH OF 2008 THE CRASH OF 2008

The outstanding feature of the crash

• f 2008 was its global reach.

Between Dec. 2007 and Dec.2008,

every single one of the world’s 40 largest stock markets had declined by significant amounts.

The DJIA dropped from about 14,000

points in Oct. 2008 to 7000 points in March 2009.

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HOW GLOBAL WAS THE CRISIS? HOW GLOBAL WAS THE CRISIS?

The Russian and Chinese markets

declined by 69%, Greece by 67%, Venezuela by 60% and Indonesia by 58%.

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ECONOMIC GROWTH & FINANCIAL ECONOMIC GROWTH & FINANCIAL CRISES CRISES

When Adam Smith wrote “The Wealth

• f Nations” in 1776 the richest country

in the world was 4 times richer than the poorest country.

The richest regional bloc (Europe) was

about 3 times richer than the poorest (Africa).

Thus, in 1776 income inequality was

not a major issue.

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POLICY, ECONOMIC GROWTH & POLICY, ECONOMIC GROWTH & DEVELOPMENT DEVELOPMENT

Today, the difference between countries

and regional blocs are:

Inequality between countries and regional

blocs since the time of Adam Smith has increased tremendously.

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Qatar: $87,717 Congo: $334

• W. Europe

$19,264 Africa $1474

Source: IMF.

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GROWTH DIFFERENTIALS GROWTH DIFFERENTIALS

What was the difference in the growth

rates of the richest and the poorest country blocs that accounts for the current level of income disparity?

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WORLD GROWTH WORLD GROWTH

Region 1820 2000

Annual Growth Rate

Western Europe $1202 $19,264 1.6% Africa $420 $1474 0.7%

Differential Growth Rate (W. Europe vs. Africa)

0.9%

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ECONOMIC GROWTH ECONOMIC GROWTH

Small growth divergences over long

periods lead to huge differences. Financial crises matter because they slow down growth for several years.

Effective management of financial

crises is like medicine – short term discomfort for substantial long term benefits!

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4. 4. Financial Instability and Financial Development Financial Instability and Financial Development

4.3 4.3 Foundation of Sound Regulation Foundation of Sound Regulation and and Supervision Supervision

Financial crises will never be altogether eliminated, the

frequency and cost of such crises can be reduced if appropriate supervision and regulation is applied.

Issues of reforms in supervision and regulation of

financial institutions

• The system of compensation of bankers and agents should be fixed.
• The current model of securitization has serious flaws.
• Non-bank financial institutions should be brought into regulation and

supervision

• Market discipline approach of regulation should be developed.
• Shortcomings related to capital requirements and other issues in Basel II

should be overcome.

• Role of credit rating agencies
• Fixed inadequate regulatory regime
• More international coordination

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5. 5. Financial Inclusion Versus Financial Development Financial Inclusion Versus Financial Development

5.1 5.1 Concepts Concepts

• Financial inclusion: drawing unbanked population into the formal financial

system.

• How? – not by disregarding risks and other costs when deciding to offer

services, nor by forcing everybody should make the use of financial services

• but by policy initiatives that aim to correct market failure and to eliminate

nonmarket barriers to accessing a broad range of financial services. Benefits of financial inclusion:- Financial Stability, equity, growth and poverty elevation Financial Inclusion: Current state

• A global survey of regulators with regards to financial access (CGAP’s

Financial Access 2009) = 2.6 billion unbanked adults in the developing world.

• World Bank’s composite access indicator (2009) = the number of financially

excluded adults significantly exceeds the adult population living under the $2- 1-day poverty line.

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5. 5. Financial Inclusion Versus Financial Development Financial Inclusion Versus Financial Development

5.2 5.2 Current state of financial Current state of financial inclusion globally inclusion globally

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5. 5. Financial Inclusion Versus Financial Development Financial Inclusion Versus Financial Development

5.2 5.2 Current state of financial Current state of financial inclusion globally inclusion globally

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5. 5. Financial Inclusion Versus Financial Development Financial Inclusion Versus Financial Development

5.2 5.2 Financial inclusion and Poverty Financial inclusion and Poverty alleviation alleviation

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5. 5. Financial Inclusion Versus Financial Development Financial Inclusion Versus Financial Development

5.3 5.3 Financial inclusion enhances Financial inclusion enhances Stability: Stability: How? How?

Hannig and Jansen (2010) argues that Financial inclusion presents opportunities to enhance

financial stability

Financial inclusion poses risks at the institutional level, but

these are hardly systemic in nature. Evidence suggests that low-income savers and borrowers tend to maintain solid financial behavior throughout financial crises, keeping deposits in a safe place and paying back their loans.

Institutional risk profiles at the bottom end of the financial

market are characterized by large numbers of vulnerable clients who own limited balances and transact small volumes. Although this profile may raise some concerns regarding reputational risks for the central bank and consumer protection, in terms of financial instability, the risk posed by inclusive policies is negligible.

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5. 5. Financial Inclusion Versus Financial Development Financial Inclusion Versus Financial Development

5.3 5.3 Financial inclusion enhances Financial inclusion enhances Stability: Stability: How? How?

In addition, risks prevalent at the

institutional level are manageable with known prudential tools and more effective customer protection.

The potential costs of financial inclusion

are compensated for by important dynamic benefits that enhance financial stability over time through a deeper and more diversified financial system.

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5. 5. Financial Inclusion Versus Financial Development Financial Inclusion Versus Financial Development

5.3 5.3 Financial Inclusion policies: Financial Inclusion policies: what what can a central bank do? can a central bank do?

Center for Global Development (See Claessens et al. 2009) recommends ten policy principles for expanding financial access:

1.Promoting entry of and competition among financial firms. 2.Building legal and information institutions and hard infrastructure. 3.Stimulating informed demand. 4.Ensuring safety and soundness of financial service provides. 5.Protecting low-income and all customers against abuses by financial

service providers.

6.Ensuring that usury laws, if used, are effective. 7.Enhancing cross-regulatory agency coordination. 8.Balancing government’s role with market provision of financial

services.

9.Using subsidies and taxes effectively and efficiently. 10.Ensuring data collection, monitoring, and evaluation.

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5. 5. Financial Inclusion Versus Financial Development Financial Inclusion Versus Financial Development

5.3 5.3 Financial Inclusion policies: Financial Inclusion policies: what what can a central bank do? can a central bank do?

1.

Agent Banking: policies that enable banks to contract with nonbank retail agents as

• utlets for financial services

2.

Formalize microsavings: licenses for specialized institutions dedicated to taking microdeposits, licenses for nonbank financial institutions, bank licenses for successfully transforming financial NGOs

3.

State bank reforms

4.

Consumer protection and education

5.

Lowering documentation barriers

6.

Mobile banking

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• 58

If global banking practices adhere to the principles of

Islamic finance, which are based on noble ideas of entrepreneurship and transparency, global crisis would have been prevented

Shariah principles:

Not to sell a debt against a debt: one can’t sell or lease

unless he/she posses real assets

Islamic finance is based on equity rather than debt, and

lending transactions are founded-on the concept of assets backing: mortgage loans under such system would have been backed by solid asset structure

• 59
• 60

Shariah principles continued:

Islam takes particular interest in fostering close relationship

and trust between originators (financial institutions) of Islamic financial products and investors

Absence of an adequate and effective regulatory control

system that monitors and consequently ensures the interests of investors. Potential investors are well versed about the prospects (opportunities and risks) that their investments are subject to when entering into new contracts

• Risk must be explicitly communicated !

Honest implementation of Profit-and-Loss Sharing (PLS)

transactions (such as Mudarabah and Musharakah contracts) in accordance with the spirit of Shariah entails full disclosure and transparency

Islam regards the relationship between the lender (financial

institution) and the borrower (investor) as a partnership

Riba prohibited

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Intuitive description

‘Earning money from money’ or interest, is prohibited.

Profit, which is created when ‘money’ is transformed into capital via effort, is allowed. However, some forms of debt are permitted where these are linked to ‘real transactions’, and where this is not used for purely speculative purposes

Linkage to ‘market failures’?

A real return for real effort is emphasised (investments

cannot be ‘too safe’), while speculation is discouraged (investments cannot be ‘too risky’). This might have productive efficiency spillover benefits (‘positive externalities’) for the economy through linking returns to real entrepreneurial effort

Fair profit sharing

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Intuitive description

Symmetric profit-sharing (eg. Musharakah) is the

preferred contract form, providing effort incentives for the manager of the venture, while both the investor and management have a fair share in the venture’s realised profit (or loss)

Linkage to ‘market failures’?

Aligning the management’s incentives with those of the

investor may (in contrast to pure debt financing) once again have productive efficiency spillover benefits for the economy, through linking realisable returns to real entrepreneurial effort

No undue ambiguity or uncertainty

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Intuitive description

This principle aims to eliminate activities or contracts that are

gharar, by eliminating exposure of either party to excessive

• risk. Thus the investor and manager must be transparent in

writing the contract, must take steps to mitigate controllable risk, and avoid speculative activities with high levels of uncontrollable risk

Linkage to ‘market failures’?

This may limit the extent to which there are imperfect and

asymmetric information problems as part of a profit-sharing

• arrangement. Informational problems might, for example,

provide the conditions for opportunistic behaviour by the venture (moral hazard), undermining investment in all similar ventures in the first instance.

Halal versus haram sectors

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Intuitive description

Investing in certain haram sectors is prohibited (eg,

alcohol, armaments, pork, pornography, and tobacco) since they are considered to cause individual and/or collective harm.

Linkage to ‘market failures’?

Arguably, in certain sectors, there are negative effects for

society that the investor or venture might not otherwise take into account (negative externalities). Prohibiting investment in these sectors might limit these externalities

Practice of Islamic Finance Practice of Islamic Finance

IF regulatory environment in elementary stages

and still evolving

Excessive profit/risk-taking—difficult to impose

moral order

Episodes of speculation observed in the Gulf states Innovations and Financial Instruments Fixed income assets—No risk-sharing Sukuk

Risk transfer through securitization Do investors have control over assets?

Return-swap

Returns on assets can be swapped with return on any class of assets (including sub-prime CDOs) Capital efficient solutions?

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Could the Crisis Occur in IF? Could the Crisis Occur in IF?

Conventional

• 1. Banks/financial institutions

engaged in sub-prime lending

• 2. Loans packaged as

MBS/CDO

• 3. Rating Agencies gave

positive ratings to these securities

• 4. Investors bought securities
• 5. Bought Credit Default Swaps

(CDS) to hedge credit risks

• 6. Issuers of CDS took on the

risk of default Islamic

• 1. IFIs can be engaged in sub-

prime financing with lax RM

• 2. If financing is ijarah/Dim.

Musharakah, assets can be securitized as sukuk

• 3. Risks of Islamic instruments

complex and difficult to assess

• 4. Investor buys securities
• 5. Investors can buy return-swaps

that exchanges returns of sukuk with return on other asset class

• 6. Issuers of swaps take up the

risk of sukuk

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Concluding Remarks

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Concluding Remarks

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Concluding Remarks

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Selective References: Selective References:

• Armour, John, Simon Deakin, Viviana Mollica and Mathias M. Siems (2010), “Law and Financial

Development: What We Are Learning from Time-Series Evidence.” European Corporate Governance Institute (ECGI) - Law Research Paper Series No. 148/210

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